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An Economic Order Quantity Model with

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Int. J. Emerg. Sci., 1(3), 465-477, September 2011
ISSN: 2222-4254
© IJES

An Economic Order Quantity Model with

Shortages, Price Break and Inflation

Onawumi. AS, Oluleye. OE. and Adebiyi. KA.

Department of Mechanical Engineering

Ladoke Akintola University of Technology Ogbomoso, Nigeria.
Department of Industrial and Production Engineering
University of Ibadan, Ibadan.
Department of Mechanical Engineering
Ladoke Akintola University of Technology Ogbomoso, Nigeria.

ayoyemi2001@yahoo.com, ayodeji.oluleye@mail.ui.edu.ng, engradebiyi@yahoo.com

Abstract. The effect of inflation has become a persistent characteristic and

more significant problem of many developing economies especially in the
third world countries. While making effort to achieve optimal quantity of
product to be produced or purchased using the simplest and on the shelf
classical EOQ model, the non-inclusion of conflicting economic realities as
shortage, price break and inflation has rendered its result quite uneconomical
and hence the purpose for this study. Mathematical expression was developed
for each of the cost components the sum of which become the total inventory
model over the period (0, L) (TIC(0, L)). Significant savings with increase in
quantity was achieved based on deference in the varying price regime. With
the assumptions considered and subject to the availability of reliable inventory
cost element, the developed model is found to produce a feasible, and
economic inventory stock-level with the numerical example of a material
supply of a manufacturing company in Nigeria.
Keywords: Inflation rate, Inventory Management, Interest rate, Price break,
Shortage Cost.

1 INTRODUCTION

The classical economic order quantity (EOQ) model seeks to find the balance
between ordering cost and carrying cost with a view of obtaining the most economic
quantity to procure by the distributor. Literature reveals that sometimes up to
60percent of the annual production budget is spent on material and other inventories
[5],[11]. An effective customer friendly and efficient supply system could be
achieved by operating on economic order supply level (EOSL). Limiting conditions
inherent in the traditional EOQ model give opportunity for several other inventory
models which are published in some Journals [7],[13]. In this paper economically
realistic situation where the availability of quantity discount which results in price
break is explored in the face of double digit inflation rate and possible shortage of
needed supply was considered and modeled. Incessant economic recession

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 Onawumi. AS, Oluleye. OE. and Adebiyi. KA.

worsened with the alarming inflation rate is a common trend in many third world
countries. This is an issue of economic concern that necessarily requires major
attention on management of inventory of products [12]. One of the advantages often
explored to cushion the burden of net inventory cost and to enjoy substantial
savings is the benefit from procuring large enough quantity that reduces the unit
price of the item. Likewise in the absence of capacity restriction, the replenishment
cost per unit is reduced as the quantity is increased. While procured quantity cannot
be uncontrolled due to the adverse effect it could have on holding cost which ought
to be held minimum, optimal inventory cost is only possible as all considered costs
are balanced up [17]. It is evident that any quantity above the EOQ is a loss to the
buyer who invariably is forced to reduce quantity procured to a level close to the
calculated optimal quantity. Seller on the hand could loose sales as a result of this
customer’s decision. To encourage buyer to increase his buying interest without
experiencing any loss seller could provide price incentives to purchase large which
in effect reduce price per unit. This could shift the EOQ in favor of both the seller as
well as the buyer [12]. Quantity price structure is then considered as a benefit made
available by manufacturer/seller as a matter of marketing policy to encourage
retailer who buys larger quantity than actual order. The varying peculiarities of the
supply inventory categories as well as divergent operating factors affecting
inventory has contributed to the lack of particular inventory model that has general
applications to the entire variants inventory situations. Consequently a variety of
inventory models have emerged which address specific inventory problems [6],
[9],[16]. In like manner the recent problem of economic meltdown also possesses
much task on investment managers in the area monitoring the effects of inflation
together with interest rate (return on capital) in relation to inventory problems.
Usually, the problem is that of balancing the costs of less–than–adequate inventory
(Under-stocking) and that of cost of more-than-adequate inventory (Over–stocking).
The goal is to have adequate items at all times at minimal cost [7],[14][15]. Solution
methods used for solving these problems are basically analytical techniques and the
sophisticated application of mathematical programming. However, the
mathematical complexity of the resulting models increases as we move away from
the assumption of deterministic to probabilistic non-stationary demand [10],[14].
Silver [13] reviewed many classifications of the inventory problem, highlighting the
limitations while also advocating the bridging of the gap between theory and
practice. Buzacott, [3] noticed that the assumption of the classical EOQ formula that
all relevant costs and prices cannot be valid in an economy that is plagued with
double digit annual inflation rate and therefore developed an inventory model with
inflation factor included. He suggested obtaining the optimal order quantity by a
process of iteration. However closer examination reveals that the solution method is
indeed an approximation; because of the assumption inherent in his use of a
quadratic approximation. This paper considered an approach that seeks to balance
the advantages of lower prices for purchased items and fewer orders and the
disadvantages of the increased inventory holding cost. The amounts generally
includes expected demand during lead time and perhaps an extra cushion of stock,
which serve to reduce the risk of experiencing a stock-out during lead-time
especially in the environment when variability is present in the demand, in the lead-
time, or in both [2]. Generally, the determination of the optimal policy of an

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 International Journal of Emerging Sciences, 1(3), 455-464, September 2011

inventory model with a stochastic demand includes the calculations of the reorder
point and the order size which involve the mean rate of the demand, the demand's
standard deviation, the safety factor, and the forecasted lead-time.

2.0 MODEL DEVELOPMENT

Using the principles of the classical EOQ model, the following assumptions are`
made:
1. Demand rate is determinable and constant.
2. Supplies are delivered in batches.
3. Replacement is instantaneous on request.
4. Inflation rate is assumed constant over a period of time.
5. Unit purchase cost and other relevant costs are affected by inflation.
6. Shortages are allowed at a cost and over a given back-ordering time frame.
7. Purchase costs per unit change with quantity with discount.
The situation of a determinable demand rate in which shortages are allowed is
illustrated in Figure 1. The shortages could be backordered within the limit of the
backlogged of the demand. The maximum inventory level is S and occur when the
inventory is replenished. The lot size is less than the order level as a result of the
backorder.

S
Inventory Level

Q/D 2Q/ Time

D

Figure 1. Lot-size model with shortages allowed

The following notations are used in the model development.

Co
Initial Purchasing cost/Unit
C1 Set up cost
C2 Holding cost/Unit/Unit time
C3
Shortage cost /Unit/Unit time
C (t ) Cost at time t
C (0, L ) Ordering Cost over the period (0, L)
D Demand rate

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 Onawumi. AS, Oluleye. OE. and Adebiyi. KA.

MT Megaton
R Rate of return on inventory investment
k Effective inflation rate
l Number of orders
L Planning Horizon
S Maximum inventory level
q Lot size
I Inventory cycle
t1 Time interval before shortage
t2 Shortage period
T Ordering interval
C01 Purchase cost per unit at q1
C02 Purchase cost per unit at q2
q1 Quantity at first Price break
q2 Quantity at Second Price break
ym Quantity at which TIC(L,T) is at minimum
TIC ( L , T ) Total Inventory cost over period (0,L) using ordering interval T
Total inventory cost over the period (0, L), can be expressed as
TIC ( L , T ) = (Set-up costs) + (Shortage costs) + (Holding costs)
+ (Purchase costs) (1)
The expression for each cost component is derived as follow:

2.1 Ordering or Setup cost over the period (0, L)

A simplifying assumption is that the ordering or setup is an aggregate of a fixed cost

that is independent of the amount ordered, and a variable cost that depends on the
amount ordered. This is the cost of placing an order to an outside supplier or
releasing a production order to a manufacturing shop. It includes amongst other cost
elements Clerical/labor costs of processing orders, inspection and return of poor
quality products, transport costs and handling costs. The cost estimation of this cost
taking into consideration all known cost elements is quite cumbersome. The
quantity ordered also known as lot size is q. C1(T) is often a nonlinear function.
Considering that cost increases with time then it is expressed as:
C1(T )  C1kT (2)
Assuming of batch supplies then
L  lT
Over the period (0, L) then
C 1 ( 0 , L )  C 1  C 1 ( T )  C 1 ( 2 T )  .......... .......  C 1 (( l  1) T ) (3)

Therefore,

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 International Journal of Emerging Sciences, 1(3), 455-464, September 2011

l 1
C 1 (0, L )  C
n0
1  KTn


C 1 ( 0 , L )  C 1  C 1  KT  C 1  2 KT  ......... C 1  ( l 1) KT  (4)
The geometric series can then be expressed as
 e kL  1  (5)
C1 (0, L)  C1  kT 
 e  1

2.2 Holding costs over the period (0, L)

This is one of the vital costs that needs to be optimized in any logistics system. It is
a well-known fact that the inventory holding costs is a part of the total logistics
costs of a firm. It is also referred to as the cost of carrying an item in inventory for
some given unit of time. This inventory cost component includes the lost investment
income caused by having the asset tied up in inventory. Specifically holding cost is
assumed to be a variable cost with cost components which include: Storage costs,
Rent/depreciation, Labor, Overheads (e.g. heating, lighting, security), Money tied
up (opportunity cost, loss of interest), Stock deterioration (lose money product due
to deterioration whilst held), Obsolescence costs (if left product exceeds its useful
life) and insurance [11],[13], [17] This is not a real cash flow, but it is an important
component of the cost of inventory.
During each order ordering period, the holding cost can be expressed as
T t2

 DC (T,T  w)dw
w0
2
(6)
over the period (0,L) we then have
l 1 T t2
C2 (0, L)    DC2 (T, T  w)dw
n0 w0
(7)
but
C 2 ( nT , nT  w )  RC 2 (T ) w

that is
DR(T  t 2 ) 2 l 1
C2 (0, L) 
2
 C2 (T )
n 0 (8)
but
C 2 ( T )  C 0  C 0 e KT  C 0 e 2 KT  .......... .......  C 0 e ( l  1 ) kT
Then the holding cost over the period (0,L) is expressed as:
C DR(T  t2 )2  ekL  1
C2 (0, L)  0  kT 
2  e  1 (9)

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 Onawumi. AS, Oluleye. OE. and Adebiyi. KA.

2.3 Shortage costs over the period (0, L)

When a customer seeks the product and finds the inventory empty, the demand can
either go unfulfilled or be satisfied later when the product becomes available. The
former case is called a lost sale, and the latter is called a backorder [8],[16]. The risk
associated with stock out situation could place serious challenge on the firm’s
customer service and goodwill. This cost includes penalty costs, machine idleness
cost, operator idleness costs, loss of sales and cost of goodwill. It is also assumed to
be proportional to the number of units backordered and the time the customer must
wait. The constant of proportionality is p, the per unit backorder cost per unit of
time. (N/unit-time).

Shortage cost per period of time according to Buzacott, [1] is given by

t2

 DC (T )m dm
n0
3
(10)
Thus over the period (0, L) the shortage cost becomes:
l 1 T
C3 (0, L)    DC (nT, nT  m)dm
3
n o m T t1

But
T-t1 = t2
Hence
Dt
2
 ekL  1
C3 (0, L)  2  kT 
2  e  1 (11)

2.4 Purchasing Costs over the period (0, L)

This is the unit cost of purchasing the product as part of an order. This include price
paid on labour, material and overhead charges necessary to produce the item,
[3],[14]. The product cost may be a decreasing function of the amount ordered
especially in the case of purchase of large quantity which creates room for quantity
discount. (N/unit).
The initial purchase cost is DTC0
But cost increases over time such that
C ( t )  C 0 e kt
(12)
Purchasing cost over the period (0, L) is then given by
C1 (0, L)  DT(C0  C0 (T )  C0 (2T )  C0 ((l  1)T )
That is
(l 1)
C0 (0, L)   DTC0e kTn
n0 (13)

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 International Journal of Emerging Sciences, 1(3), 455-464, September 2011

This yield
 ekL 1
C0 (0, L)  DTC0  kT 
 e 1 (14)
The total inventory cost over period (0, L), TIC (0, L), was obtained by adding
all the component costs developed in equations 5, 9, 11 and 14.
 C DR(T  t2 )2 2  ekL 1
TIC(0, L)  C1  0  C3Dt2  C0TD kT 
 2  e 1 (15)
Given the objective of minimizing costs, the solution can be obtained by
iteration (varying T values to obtain minimum cost).

2.5 Quantity Discount

Price breaks are introduced at q1 and q2 as shown in Figure 2. These two differ
from ym
ym ≤ q1: In this case, the first price break is introduced. Corresponding price
offered for this is Co1. TIC(ym) = TIC(y*) if it is the least cost and also feasible at
any value less than q1.
q1<ym<q2: This indicates the existence of further price break with quantity
between q1 and q2. The range in the quantities creates a limitation for the possible
solution.
q2 ≤ ym: The second quantity that provide incentive for buyer at a much more
reduced price C02. TIC(ym) = TIC(y*) if at a quantity equal to or greater than q2,
there exist a feasible solution that is less than other feasible solutions [16].


 TIC(ym ) ym  q1
TIC(0, L )  TIC(q ) q  y  q
1 1 m 2
 TIC(q ) q  y
 2 2 m
(16)

TIC(0,L)(N)

471

0 ym q1 q2

Q
 Onawumi. AS, Oluleye. OE. and Adebiyi. KA.

Figure 2. Price Break at q1 and q2

3. APPLICATION

In order to demonstrate the application of the proposed model, data for an imported
item, in respect of a cement manufacturing company in Nigeria was obtained.
Questionnaires, interviews and company record were utilized to generate the
relevant data. Basic data for which the model was applied were stored in
spreadsheet format and graphed using EXCEL 2007. Data used include: Times were
varied with minimal interval (T= 0.01year) in order to locate point of inflection on
the concave graph obtained. The optimal reorder period (T*) was obtained at
minimum total inventory cost. Optimal reorder quantity is then: Q* = T*D
(16)
Unit cost
C0  (at ≤ ym) = N 120, 000 / MT
Ordering Cost
C1  = N 100, 000 / MT
Stock out cost 3
C  = N 50, 000 / MT
Annual Demand (D) = 250MT
Effective Inflation rate (k) =25%
Interest rate (R) = 40%
Time shortage is allowed (t2) = 1month
Planning horizon (L) = 1year
Quantity for which no discount is allowed (q) = ≤ 75MT
Quantity at first Price Break (q1) = 76-105MT
Quantity at Second Price Break (q2) = >105
Price Break at q1 (Co1) = N105,000/MT
Price Break at q2 (Co2) = N95,000/MT

4. DISCUSSION

Table1 presents the inventory stock level for different unit prices for varying
quantities. The stock level obtained where checked if feasible within the limit
allowed for price per unit to be discounted. The feasible price break quantity exists
between 76 and 105MT having price per unit of N105,000 and minimum inventory
cost of N3013761.27. The associated order interval is 0.32 (3.125orders).

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 International Journal of Emerging Sciences, 1(3), 455-464, September 2011

Table 1. Feasible Total Inventory Cost

Q (for Price Break) Q* Co(N/MT) TIC (N)

<76 75 120000:00 34371059.08
76-105 80 105000:00 30137511.27*
>105 85 95000:00 27312824.48

Figure 3 shows that the best purchase quantity for which the deepest discount is
found on q1 curve with corresponding value of 80MT.
A comparison with current inventory cost of N35,664,453.00 shows a decrease
of 15.5%. This is indicative of the significant benefits derivable from the use of the
model by the organization.
Figure 4 shows that price per unit varies with purchase quantity at different
levels of price break Figure 5 however shows that the inventory cost is quite
sensitive to available price level and that the higher the quantity the lower the total
inventory cost.
The significant effect of shortage period allowed is noticed in Figure 6 which
support longer shortage interval. However, Figure 7 shows that while inventory
costs vary with shortage periods allowed; the ordering policy is not as sensitive. It is
indeed a step function. This implies that while the shortage period may vary, the
number of orders required in the planning horizon may not. In real terms however,
we note that an organization would probably prefer to let the number of orders be an
integer value. Given, this the optimal cost and number of orders can then be
calculated by perturbation. For example, given the solution of 3.125orders/annum
obtained in the case examined and compared with the cost of 3orders/annum and
4orders/annum respectively in the planning horizon, the policy with lesser cost is
then chosen. In this case, 3orders/year yields a savings of 15.5%.
The combined effect of inflation and interest rate are reflected in the value of
total inventory cost. While increase in interest rate has lead to significant increase in
the total inventory cost, inflation rate on the other hand is responsible for the
reduction in the effective value of total inventory cost. The frequency of reorder
contributed to high rate of increase in holding cost and consequently to increased
TIC with inflation. It important to note that inflation rate is a necessary factor in the
determination of effective lending rate in a growing economy.

5. CONCLUSION

We have reviewed the importance of inventory cost minimization with a view to

increasing organizational profitability and liquidity. The sensitivity of total
inventory cost to price break has been demonstrated with significant cost savings.
An inventory model which considers shortages, inflation factors and price break
incentive was derived and applied to a case example; in order to highlight the utility

473
 Onawumi. AS, Oluleye. OE. and Adebiyi. KA.

of the model. The reliability of this model depends on the correctness of the
inventory cost elements used which is outside the scope of this study. Special
emphasis is placed the effect of bulk purchase that can enhance saving on inventory
in the face of inflationary situation. However the benefits derivable from the
utilization of the model appear immense.

50000000

45000000

40000000
TIC(N) q2
35000000
q1
q
30000000

25000000
0 0.1 0.2 0.3 0.4 0.5
0.3
2 0.3
Quantity (MT) 4

Figure 3. Inventory Cost Profile

37000000
Inventory Cost (N)

35000000
33000000
31000000
29000000
27000000
25000000
74 76 78 80 82 84 86
Quantity (MT)

Figure 4. Quantity Discount level

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 International Journal of Emerging Sciences, 1(3), 455-464, September 2011

Figure 5. Unit Price Profile

Figure 6. Shortage Period Cost Profile

Figure 7. Ordering Policy Profile

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 Onawumi. AS, Oluleye. OE. and Adebiyi. KA.

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